Debt consolidation as a financial tool has been around in one form or another for years. While it may sound like a complicated industry term used by experts, it is actually a fairly simple concept for rolling multiple unsecured debts into one single loan for the purpose of debt repayment.
What Is Debt Consolidation?
In its simplest terms, debt consolidation is when you take out one big loan and use it to pay off a bunch of smaller loans. It is important to note that mortgages, federal student loans, and car payments cannot be consolidated. Most unsecured debts are eligible – that is anything not backed by collateral such as credit cards, medical bills, and payday loans. These debts typically carry very high interest rates, sometimes as high as 32%, and if you are making only the minimum payments, it can often feel like you are swimming upstream and getting nowhere.
What Are the Benefits and Options?
Debt consolidation is different from debt settlement in that it does not negotiate the amounts on the debt you owe; you still owe what you owe. But debt consolidation can significantly streamline your budget. By consolidating your debt into one loan, you will no longer be making multiple payments to many different creditors each month. Instead, you will make one single payment on the consolidated loan. Additionally, you can oftentimes lower your payment (which means you have more money in your monthly budget) and lower your interest rate (which means you’ll pay less over the life of the loan).
There are several different ways to go about consolidating debt. One way is to apply for a lower-interest credit card and transfer all other debts to that one card. If your credit score is good, this is where it could really pay off if you shop around. Many credit card companies often offer introductory promotional rates on balance transfers – some as low as zero percent – so for the savvy researcher, this could add up to incredible savings. Be sure to read the fine print, though, and make plans to pay the balance off before the promotional period ends. You don’t want to get caught still owing a balance after the interest rates increase, or you could end up paying more in the long run.
Another way to consolidate debt is to apply for a low-interest bank loan and roll all of your unsecured debt over to a single loan. There are a couple of the benefits to this approach. For one, it establishes a set monthly payment, which helps in budgeting. It also establishes a set pay-off date, giving you a definite timeline for debt repayment. If it is a 3-year loan, you know the debt will be paid off in three years. Just be sure to look for a fixed interest rate that will not go up over the life of the loan.
Depending on your personal financial circumstance, you may also have access to other forms of credit such as a home equity loan or the option to borrow against your 401K to help pay off unsecured debts. These options both pose higher risk because they tie up assets in the short term, so you will want to weigh the benefits against the risk before making this choice.
Does Debt Consolidation Make Sense for Me?
First, find out your credit score. While it is not necessary to have excellent credit, you will need to have a high enough score to qualify for a lower-interest credit card or a low-interest consolidation loan. Different plans require different minimum scores, so it will be necessary to have this information handy while doing your research.
Next, know what you owe. Make a list of all your unsecured debt. Include the total amount owed to each creditor, the interest rate you are paying for each, and your monthly payments. Calculate your debt-to-income ratio by adding up your total monthly debt (be sure to include: mortgage, student loans, and auto loans) and dividing it by your total monthly income. If you owe more than 50% of your income towards your debt, debt consolidation might not be right for you. In this case, you may need to look at more comprehensive debt relief options. On the flip side, if your debt-to-income ratio is less than 15%, debt consolidation might not be necessary – you might benefit more by just paying more each month until you are debt-free. But if your debt-to-income ratio falls between 20% and 35%, consolidation might be a good debt repayment option for you.
Most importantly, you need to have an overall goal to get out of debt. Debt consolidation can be an incredibly effective strategy for paying off debt and improving your overall financial health, but it does come with one hidden danger: If you continue to rack up debt even after debt consolidation because you charged up those same credit cards that you consolidated, you could wind up in a far worse condition than you started.
If you have good credit, know your debt-to-income ratio is between 15% and 35%, and are serious about paying off debt, debt consolidation might be the right option for you. Shop around, know your options, and compare rates.
If you still have questions and would like to talk to an expert, one of our knowledgeable team members at American Credit Foundation would be happy to help you talk through all of your options. We’d love to share tips and best practices that we know will work to bring you out of debt.